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The Better Choice for Entity Selection

The following list provides a brief description of the common types of entities available in most jurisdictions, i.e., Entity Selection — Sole Proprietorship , Partnership , LP , LLP , LLC , S Corporation , Corporation , Nonprofit Corporation. We explain some of the pros and cons applicable to these various types of entities. Notably, the list proceeds from the simplest to the more complex forms of entities, and from the least to the greatest protection against personal liability.

DISCLAIMER: This page does not provide an all-inclusive list of every type of business entity, nor a complete description of all of the issues to be considered in selecting an appropriate entity. Competent legal counsel by a licensed attorney should be obtained regarding the choice and formation of a legal business entity.

SOLE PROPRIETORSHIP – The sole proprietorship is the simplest form of business entity. It is a form in which an individual conducts business in his or her own name or under a trade name rather than a separate legal business entity.

PROS:

There is no requirement to register a sole proprietorship with the state (unless you are using a trade name, in which case, you should register the trade name to protect it from use by others).

There is no double taxation applicable to the sole proprietorship. The sole proprietor is taxed at his or her individual tax rate for the profits earned in the business, under his or her individual name and social security number on his or her individual tax return (Schedule C of IRS Form 1040). There is no business entity level tax.

There are no corporate formalities to conduct or maintain.

Sole proprietors have complete control over the business

CONS:

There is no limitation of personal liability for the sole proprietor, which means that liabilities, debts, and judgments against the business can attach to the personal assets of the sole proprietor including personal bank accounts, cars, and homes.

PARTNERSHIP / JOINT VENTURE – A partnership or joint venture is a form of business enterprise in which two or more “individuals” (or entities) participate for profit. Individuals can be deemed to be in a partnership even if they have not entered into a formal partnership agreement. Absent a partnership agreement, state laws govern the rights and responsibilities of partners, such as requiring that each partners share equally in the profits of the business. A joint venture is a type of temporary partnership that is organized to carry out a particular business enterprise.

PROS:

There is no formal requirement to register a partnership with the state (although recommended)

There is no double taxation applicable to the partnership. Partnerships are pass-through entities, which means that each partner is taxed at his or her individual tax rate for their share of the profits earned in the business, under his or her individual name and social security number. There is no business entity level tax, although the partnership is considered an entity separate from each partner, but the partnership should file an informational federal return ( IRS Form 1065) and K-1 forms should be sent to each partner representing their share of profits.

The corporate formalities are not mandatory to conduct or maintain.

All partners can act on behalf of the partnership.

CONS:

There is no limitation of personal liability for the partners in a partnership, which means that if someone sues the business and wins, they can attach a judgment against the personal assets of each partner including their personal bank accounts, car, and home.

Partners are financial liable for the actions of their partners, which means that someone can sue the partnership for the conduct of one of the partners in his role as a partner in the business and the assets of not only that partner, but all of the partners can be attached to satisfy a judgment.

All partners can act on behalf of the partnership.

LIMITED PARTNERSHIP (LP) – A limited partnership is an entity formed under state law by two or more “individuals” associated for the purpose of conducting a business for profit. The LP consists of one or more limited partners and at least one general partner (Note: general partners can be corporations in order to further limit personal liability).

PROS:

The personal liability of limited partners is limited to their contribution of capital in the LP.

There is no double taxation applicable to LPs. LPs are pass-through entities, which means that each limited or general partner is taxed at his or her individual tax rate for their share of the profits earned in the business, under his or her individual name and social security number. There is no business entity level tax, but the LP should file an informational federal return and K-1 forms should be sent to each limited and general partner representing their share of profits.

The corporate formalities are not mandatory to conduct or maintain.

CONS:

There is no limitation of personal liability for the general partners of the LP, which means that if someone sues the business and wins, they can attach a judgment against the personal assets of the general partner(s) including their personal bank accounts, car, and home.

General partners are financial liable for the actions of their partners, which means that someone can sue the partnership for the conduct of one of the partners in his role as a partner in the business and the assets of not only that partner, but all of the general partners can be attached to satisfy a judgment.

Limited partners cannot participate in the management of the LP.

LIMITED LIABILITY PARTNERSHIP (LLP) – An LLP is an entity formed under state law by two or more “individuals” associated for the purpose of conducting a business for profit. Partners in an LLP are generally personally liable for their own wrongful acts and the acts of those whom they directly supervise. However, their personal assets are protected from claims involving the wrongful acts of another partner.PROS:

The personal liability of partners is limited to their contribution of capital in the LLP unless they or someone they directly supervise has acted wrongfully.

There is no double taxation applicable to LLPs. LLPs are pass-through entities, which means that each partner is taxed at his or her individual tax rate for their share of the profits earned in the business, under his or her individual name and social security number. There is no business entity level tax, but the LLP should file an informational federal return ( IRS Form 1065) and K-1 forms should be sent to each partner representing their share of profits.

The corporate formalities are not mandatory to conduct or maintain. All partners can participate in the management and conduct business of the LLP.

CONS:

Some states limit the types of enterprises that can be formed as an LLP.

LIMITED LIABILITY COMPANY (LLC ) – An LLC is an entity formed by one or more individuals under state law. The owners of an LLC are called members (rather than shareholders) and the LLC is treated as a partnership for federal tax purposes.

PROS:

The personal liability of an LLC member is limited to their contribution of capital in the LLC, which means that if someone sues the business and wins, they can attach a judgment against the capital contribution of the member(s), but not the personal assets of the member(s) (unless the corporate veil is pierced).

There is generally no double taxation applicable to LLCs. For federal tax purposes, single-member LLCs are disregarded as entities separate from their member(s) and multiple-member LLCs are treated as partnerships (pass-through entities) for federal tax purposes unless the LLC has more than two of the four characteristics that define corporations: limited liability to the extent of assets; continuity of life; centralization of management; and free transferability of ownership interests, in which case it will be treated as a corporation. If the LLC satisfies the requirements to be disregarded or treated as a pass-through entity, the member(s) is taxed at his or her individual tax rate for their share of the profits earned in the business, under his or her individual name and social security number, and there is no business entity level tax. The LLC should file an informational federal return and K-1 forms should be sent to each member representing their share of profits.

The corporate formalities are not mandatory to conduct or maintain.

LLC members can manage the business.

LLCs can have one member or multiple members.

CONS:

Because of its relatively new form in most states, common law applicable to LLCs is not as established as with partnerships and corporations. Therefore, principles such as “piercing the corporate veil” are less defined and predictable when applied to LLCs.

In addition to income taxes, LLC members must pay self-employment taxes if they have earned more than $400 from the business during the tax year (the rate of self-employment taxes is approximately 15%).

S CORPORATION – An S corporation is a corporation organized under state law that has elected to be treated as a subchapter S corporation under federal tax law. Sections 1361 through 1379 of Subchapter S in the Internal Revenue Code provide special requirements for obtaining and maintaining S corporation status.

PROS:

The personal liability of an S corporation shareholder is limited to their contribution of capital to the S corporation, which means that if someone sues the business and wins, they can attach a judgment against the capital contribution of the shareholder(s), but not the personal assets of the shareholder(s) (unless the corporate veil is pierced).

There is no double taxation applicable to S corporations. S corporations are pass-through entities if the applicable federal tax rules are followed (e.g., earnings and profits of S corporations must be distributed to shareholders annually as dividends). There is no business entity level tax, but the S corporation must file an informational federal return (Form 1120S) and K-1 forms must be sent to each shareholder representing their distributions from earnings and profits.

S corporation shareholders can participate in the management of the business.

Shareholders can receive a portion of their income as a salary (it must be a reasonable salary) and any additional income above the salary will not be subject to self-employment taxes (a savings of over 15%).

CONS:

There are corporate formalities to conduct and maintain, such as organizational and annual meetings, corporate minutes, etc.

All income must be distributed to the shareholders annually.

Specific rules must be followed in order to maintain S corporation status:

An S corporation must be a domestic corporation and not an ineligible corporation (an ineligible corporation includes a financial institution, which uses the reserve method of accounting for bad debts, an insurance company subject to tax under Subchapter L, a corporation to which an election under section 936 applies, or a DISC or former DISC).

An S corporation cannot have more than 100 shareholders.

An S corporation cannot have a shareholder who is not an individual (certain narrow exceptions apply).

An S corporation cannot have a nonresident alien as a shareholder.

S corporation cannot have more than 1 class of stock.

C CORPORATION (REGULAR CORPORATION) – A corporation is a business entity organized under state law for the purpose of making a profit. Corporations can be closely held (have only one or a small number of shareholders) or publicly traded (shares are sold on the public market). The shareholders (owners) of a corporation elect directors (for the Board of Directors) and officers (President, Vice President, Secretary, etc.) to manage the business of the corporation.

PROS:

The personal liability of a corporate shareholder is limited to their contribution of capital to the corporation, which means that if someone sues the business and wins, they can attach a judgment against the assets of the corporation, which include the capital contribution of the shareholder(s), but not the personal assets of the shareholder(s) (unless the corporate veil is pierced).

Corporate shareholders can participate in the management of the business as directors, officers, or employees of the corporation.

The cost of benefits provided to employees are deductible

Due to recent changes in the tax law, dividends distributed to corporate shareholders are taxed at capital gain rates (generally, 15%).

CONS:

There is a double taxation applicable to corporations. The corporation is taxed on its earnings and profits at the business entity level. In addition, when profits are distributed to shareholders as dividends, those dividends are taxed at the individual shareholder level on the individual’s tax return.

There are corporate formalities to conduct and maintain, such as organizational and annual meetings, corporate minutes, etc.

NONPROFIT CORPORATION – A nonprofit corporation is an entity formed under state law for a socially beneficial, not-for-profit, purpose that has elected and been qualified to be treated as exempt from federal taxation due its social purpose.

PROS:

The personal liability of nonprofit organization organizers is limited to their contribution of capital to the organization, which means that if someone sues the business and wins, they can attach a judgment against the capital contribution of the organizer(s), but not the personal assets of the organizer(s) (unless the corporate veil is pierced).

Nonprofit organizations are exempt from federal and state taxation.

CONS:

There are corporate formalities to conduct and maintain, such as organizational and annual meetings, corporate minutes, etc.

Tax-exempt status must be applied for on IRS Forms 1023 or 1024 and at the state level.

Specific rules must be followed in order to maintain nonprofit organizational status.